inflation.doc

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Notes on Principles of Macroeconomics

Vijaya Raj Sharma, Ph.D.

INFLATION, MEASUREMENT, AND EFFECTS

INFLATION

Inflation is a phenomenon of continuous rise in the general price level of goods andservices. Inflation is not a rise in the prices of one or just few goods, and it is also not a just one-time rise in the prices of most commodities. During inflationary periods, pricesof few goods may fall, ut prices of most goods rise.

Inflation can also e defined as a decline in the value or purchasing power of dollar. If thesupply of dollar !money" rises faster than the supply of goods and services in the country,one would e#pect a decline in the value of dollar. $hus, an increase in money supply can e a reason of inflation. %ut, there may e other reasons too. If the demand for goods and

services continuously rises faster than their supply, prices of goods and services shall risetoo. $his is called demand-pull inflation. &n the other hand, a continuous fall in supply of goods and services or a continuous rise in cost of production pushes up the general pricelevel. $his is called cost-push inflation.

CONSUMER PRICE INDEX CPI!

'or measuring inflation, an aggregate representation of prices of commodities is needed.Such a general price level is represented through a price inde#( )DP deflator is one such price inde# that we riefly introduced in an earlier chapter. $here are other price indicesalso, most notaly the *onsumer Price Inde# !*PI" and the Producer Price Inde# !PPI".

*PI is the cost of purchasing a hypothetical mar+et as+et of consumption goods ought y a typical consumer during a given period of time !generally a month", relative to thecost of purchasing the same mar+et as+et in the ase year. $he .S. %ureau of aorStatistics pulishes the *PI every month. $he %ureau sends /0 surveyors to 1,000stores around the nation to record prices of 234 consumption goods that go into themar+et as+et. et us demonstrate the method of computing *PI with a hypotheticale#ample in $ale 1.

$ale 15 6ar+et %as+et and *onstruction of Price Inde#

6onthly 6ar+et%as+et

178/Prices

1773Prices

*ost of mar+et as+et in178/

*ost of mar+et as+et in1773

30 hamurgers 91.30 92.0 973.00 917.00

4 $-shirts 10.00 18.00 40.00 :.00 jeans 4.00 4.00 48.00 48.00

1 compact disc 13.00 1.00 13.00 1.00

$otal *ost of %as+et 900.00 924.00

*PI 100 13

et 178/ e the ase year. ;hen constructing a price inde#, its value is normali<ed to 100in the ase year. $hen, the value of price inde# in any year t can e calculated as5



!=>uation 1" 100 xYear Baseinbasket market of Cost

t Year inbasket market of Cost PI t =

?ccording to the aove e>uation, *PI in 1773 @ !24A00"B100 @ 13, which implies thatthe general price level increased y 3 percent during the 11-year period from 178/ to

1773. $he aove is a general formula for calculation of any price inde#. )DP deflator andPPI also are calculated similarly. $he formula is the same for any price inde#, the onlydifference among different price indices is the items that go into the mar+et as+et.

In *PI the mar+et as+et consists of only the consumption goods, ecause the ojective isto measure the effect of inflation on households. In PPI, the mar+et as+et consists of producer goods, li+e energy, raw materials, and intermediate goods. In )DP deflator, the as+et consists of all +inds of goods that go into the computation of )DP, which areconsumption goods, investment goods, goods purchased y the government, and thegoods internationally traded.

INFLATION MEASUREMENTInflation in any year t !Ct" is measured as the percentage change in price inde# from the previous period5

!=>uation " D100

1

1 x

PI

PI PI

t

t t

t

−

−−

=π

$ale 5 *alculation of Inflation Rate

Eear Price Inde# Inflation Rate,

1770 100 -

1771 110 F!110-100A100GB100@11

177 11 F!11-110"A110GB100@10

"#PERINFLATION

Hyperinflation is a run-away or out of controlJ inflation, a very rapid and high growthrate of prices. $here is no universally accepted cut-off rate of inflation for hyperinflation.Some economists consider /0 percent or higher monthly inflation as hyperinflation,whereas some other economists consider an annual inflation rate of 00 or more ashyperinflation.

PRO$LEMS %IT" CPI FOR MEASURIN& INFLATION

$he use of *PI for measurement of inflation has some prolems in truly measuring theeffect of inflation on households. $hey are5

1. If there has een a change in the lifestyle of consumers after the ase year, such thatthe mar+et as+et chosen in the ase year does not any more correctly represent theconsumption hait of households, *PI may not reflect the true general price level andinflation measured from such *PI may not truly measure inflation.

. *PI generally overstates inflation. ;hen prices of mar+et as+et goods rise,consumers have een oserved to sustitute away from such mar+et as+et goods to



other cheaper goods, which may or may not have een included in the mar+et as+etchosen for monitoring *PI. 'or e#ample, when prices of eef rise, consumers maysustitute it with chic+en. During the period of 17:-1780, energy prices in the S?rose y 18 percent, ut the actual energy e#penses of households were oserved tohave risen y only 140 percent. Households tend to sustitute or conserve use of more

e#pensive goods. *PI ignores this ehavior of households, y stic+ing to the same>uantity of consumption specified in the pre-determined mar+et as+et. ?ccording tosome economists, *PI overestimates inflation y aout 1 to 1./ percent. $his is areason ehind the often discussed proposal of lowering the cost of living adjustmentsof social security payments to senior citi<ens, which are currently adjusted forinflation as measured y *PI. Similarly, wages of government employees in somestates are revised y the rate of inflation measured y *PI( such adjustment of wagesis called the cost of living adjustment !*&?".J

2. *PI also tends to overstate inflation ecause it ignores >uality improvements. 'ore#ample, computers purchased in 003 at a cost of 91,300 are far superior in >ualitycompared to computers purchased in 178/ at that cost.

NOMINAL MONE# $ALANCE '( REAL MONE# $ALANCE

;e defined earlier that inflation was a decline in the value or purchasing power ofmoney. $herefore, 9,000 amount of nominal money alance stored in your safe in Eear000 is not e#pected to have the same purchasing power or real value in 003. 6oneyretains its nominal value, ut the real value erodes with inflation. Real alance is the realvalue of a nominal alance, which can e calculated y using =>uation 2.

!=>uation 2"

t

b

PI

PI xValueor Balanceal NobYear of pricesint Year inValueal or Balanceal minReRe =

If the values of price inde# were 100 in Eear 000 and 144 in Eear 003, the purchasing power or real alance of a nominal amount of 9,000 in Eear 003 is e>ual to 9,000 #!100A144", i.e., 91,288.87, evaluated in terms of prices of Eear 000. In other words, thegoods that cost 91,288.87 in Eear 000 will now cost 9,000 in Eear 003. &r, you couldsay that if you could uy ,000 pounds of apples with 9,000 in Eear 000, you can only uy 1,288.87 pounds with 9,000 in Eear 003.

REAL INTEREST RATE '( NOMINAL INTEREST RATE

et us assume initially an inflation-free world, i.e., money loses no purchasing power insuch a world. Kow, suppose that you lend me 91,000 for a year. $his ma+es you foregothe opportunity of using that money for one full year. $herefore, it is reasonale for any

lender to as+ certain compensation from the orrower for the loss of this opportunity.Suppose you desire a real return of 4 on the sacrifice. $hat is, you demand me to returnyou, esides the principal amount of 91,000, an additional 940 for compensation. Suchrate of return demanded y lenders from orrowers for compensation of loss ofopportunity to use the lent money is called the real interest rate.

*onsider also a possiility that the orrower may default. In the event of default, thelender either loses the principal amount or will have to proceed with a collection process



and even litigation in a court of law to recover the principal amount. =ach lender facessuch ris+s of defaults and therefore may include a ris+ premium in the interest rate, on topof the desired real return. et this premium e 1, which would raise the aove interestrate from 4 to /. In other words, real interest rate is the return a lender see+s forcompensation of loss of opportunity of using the lent money during the period of lending,

plus an appropriate ris+ premium.astly, allow the possiility of inflation. Inflation may erode the real return. Suppose youlent me 91,000 for a year at / interest rate. ?ccordingly, I returned you 91,0/0 at theend of the year. Eou got a return of 9/0 over and aove your principal amount of 91,000.;hat if the prices of all goods increased y 2 during this year, i.e., what if the goodsthat cost 91,000 a year ago now cost 91,020L $hen, your real return on lending is not 9/0, ut 90 only after accounting for the loss of purchasing power !9/0 minus 920". endersregularly face this possiility of inflation( therefore, they also add a premium fore#pected inflation on real interest rate. ;hen the interest rate includes e#pected inflationrate, this is called nominal interest rate.

!=>uation 4" planned i = desired r + e#pected π

where i is the nominal interest rate, r the real interest rate, and π e the e#pected inflationrate. ender adds the inflation premium simply to maintain the purchasing power of thelent amount. Interest rates that an+s and lenders >uote to potential orrowers or interestrates that are pulished in newspapers are nominal interest rates. If the actual inflationduring the period of lending happens to e e>ual to the e#pected rate, the lender reali<esthe desired real interest rate. %ut, whenever the actual inflation rate is different from whatwas anticipated y lender and orrower, the actual real interest rate collected y lender or paid y orrower would e different from the desired level. $o find the real interest rateactually earned or paid, one needs to sutract actual inflation rate from the nominalinterest rate at which lendingAorrowing happened5

!=>uation /" actual r @ i M actual π

EFFECTS OF INFLATION

People engaged in the usiness of lending and orrowing generally spend time and otherresources in predicting inflation, to form a judicious anticipation of future inflation toappropriately determine nominal interest rate. In a world of low or no inflation, scarceresources do not need to e wasted in such predictions. $herefore, controlling inflation isoften an ojective of macro policy ma+ers.

Suppose nominal interest rate in a transaction is fi#ed at 8, e#pecting inflation rate of2 and to have a real interest rate of /. %ut, if actual inflation during the period oflendingAorrowing e#ceeds the e#pected rate, the actual real interest rate earned y thelender would e lower than /. $he lender thus loses, whereas the orrower gains,whenever actual inflation is higher than e#pected. &n the other hand, orrower loses andlender gains when actual inflation is elow the anticipated rate. $hus, unanticipatedinflation redistriutes income etween lenders and orrowers.



If unanticipated inflation tends to remain high and uncertain, lenders may hesitate fromlending, which may retard investment in the economy, ecause investment often iscarried out with orrowed funds. Instead, people start accumulate assets in the form ofgold, real estate, and such other real goods to protect themselves from unanticipatedinflation.

"ISTORICAL TREND OF INFLATION IN USA

Inflation rate as measured y *PI has remained elow /./ annually in the last 0 years,generally hovering around to 2. =#cept the period of 17:-178 when inflation ratewas high, sometime doule digit, S? has a history of generally low inflation in the lastsi# decades. Prior to the Second ;orld ;ar, inflation rate was generally , and it is aout in the recent years.

Source5 S %ureau of aor Statistics, 00/.

CORE INFLATION

Inflation statistics are pulished every month. %esides overall inflation rate, core inflationis also reported. *ore inflation is calculated y ta+ing the *PI and e#cluding certain itemsfrom the inde#, such as energy and food products, which can have temporary large pricefluctuations, ecause these fluctuations can diverge from the overall trend of inflation andgive a false measure of inflation. *ore inflation is generally considered a etter indicatorof underlying long-term inflation. $he .S. inflation rate in Nuly 003 was estimated as0.4, whereas the core inflation !after e#cluding energy and food products" was just0.. $he overall inflation rate was higher in Nuly due to a sharp rise in energy prices.

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